Why is the projected value of the liabilities of adefined benefit plan dependent on the discountrate used in the valuation process?

What will be an ideal response?

The value of any series of cash flows are greatly influenced by the discount rates used. Lower discount rates representing less risky forms of borrowing will enable the present value of cash flows to be greater compared with higher discount rates. The value of cash flows associated with liabilities is highly sensitive to the discount rates used due to the long-term nature of the liabilities. More details are given below.

For defined benefit plans, the appropriate discount rate or discount rates at which the projected liabilities should be discounted has been an extensively debated topic. The first issue is whether it should be a single discount rate or a term structure of discount rates. Most would agree that the term structure of interest rates should be used. The real controversy is over which term structure from the bond sector to use. The strongest argument is for discounting using the term structure of Treasury rates. In fact, to be more specific, it is the Treasury spot rate curve that should be used based on the rates offered on Treasury strips. However, that is not the view of regulators. The Pension Protection Act requires that companies discount pension liabilities using corporate bond yields with at least an A rating (AAA, AA, or A). Because Treasury rates are lower than corporate rates, using corporate rates results in a lower value for the liabilities.

Three arguments have made in favor of Treasury rates and against high-quality corporate bond rates. First, the liabilities can be viewed as riskless cash flows that must be paid by the sponsor of the DB pension plan. Consequently, the liabilities should be discounted at default-free rates. Although Treasuries are not default free, they are the financial instrument that market participants view as having the least default risk. Second, if the ultimate purpose is to eliminate the interest-rate risk component of the liabilities, as explained later, then it is not possible for a large number of DB pension plans to create a hedging portfolio of corporate bonds with at least an A rating. That is, there is not a large enough supply of corporate bonds rated at least A for DB pension plan sponsors to eliminate interest-rate risk. Finally, what is odd about the use of corporate bond rates for discounting is that they offer a spread over Treasury rates to compensate for credit risk and liquidity risk. Consider the situation when Treasury rates are unchanged but credit spreads for all AAA, AA, and A corporate bonds increase 50 basis points. An increase in the credit spread means that the market is viewing corporate bonds as riskier from a credit perspective. As will be explained later, the result of the 50 bps increase would result in an improvement in the financial health of a DB pension plan. Consequently, as corporate bonds become riskier, a DB pension plan would be better off. Despite these arguments against the use of corporate bond rates to discount liabilities, the Pension Protection Act of 2006 allows these rates, which are now the rules of the game.